When borrowing money taxpayers often ask if the interest will be tax deductible.  The answer to the question can be complicated  and you’ll learn that not all interest you pay is deductible. The rules for deducting interest depend on whether you use the loan proceeds for personal, investment, or business purposes.  For tax purposes, the interest expense you pay can fall into any of the following categories:

Personal interest is not deductible.  Generally, this includes interest from personal credit card debt, personal car loans, home appliance purchases, and interest paid to the IRS for paying your taxes late.

Investment interest is typically paid on debt incurred to acquire investments such as stocks, bonds, mutual funds, etc. However, interest on debt to purchase or carry tax-free investments such as municipal bonds or municipal bond funds is not deductible. Your investment interest deduction is limited to your “net investment income,” which is the total taxable investment income reduced by investment expenses (other than expenses related to investments that produce non-taxable income). However, you must itemize your deductions to take the investment interest deduction.

Home mortgage interest includes the interest on a taxpayer’s primary home and one other residence. However, the debt for which the interest is deductible is generally limited to $1 million of home acquisition debt (debt used to purchase or substantially improve the home(s)) and $100,000 of equity debt between the first and second homes. Both the acquisition debt and the equity debt must be secured by the home(s) to be deductible as home mortgage interest. In addition, home mortgage interest is only deductible by those who itemize their deductions. Tax Tip: You will be allowed a tax deduction for interest paid on home equity debt even if used to purchase personal use items.

Passive activity interest includes interest on debt that’s for business or income-producing activities in which the taxpayer doesn’t “materially participate” and is generally deductible only if income from passive activities exceeds expenses from those activities. The most common passive activities are probably real estate rentals. For rental real estate activities, there is a special passive loss allowance of up to $25,000 for taxpayers who are active but not necessarily material participants in the rental. The $25,000 phases out for taxpayers with adjusted gross income between $100,000 and $150,000.

Trade or business interest includes interest on debts that are for activities in which a taxpayer materially participates. This type of interest can generally be deducted in full as a business expense.

Tracing Rules

Due to the limitations imposed on interest deductions, the IRS provides detailed rules to allocate interest expense among the various categories. These “tracing rules,” as they are called, are generally based on the use of the loan proceeds. Thus interest expense on a debt is allocated in the same manner as the allocation of the debt to which the interest expense relates. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures, i.e., “follow the money.”

These tracing rules, combined with the restrictions associated with the different categories of interest, can create some unexpected results.  Here are several scenarios:

Scenario 1: Marianna refinances a mortgage on her rental real estate and uses the loan proceeds to pay off the original mortgage and uses the balance of the loan to buy a car for personal use. She   is required to allocate interest expense on the loan between rental interest and personal interest for the purchase of the car. Although, the loan is secured by the rental real estate, the personal loan interest portion is not deductible.

Scenario 2: Brandon borrows $50,000 secured by his home to be used in his consulting business. He has no other equity debt on his home. He deposits the $50,000 into a checking account only used for his business. Normally, he would be unable to deduct the interest in his business and must instead deduct the interest as home equity debt interest on his Schedule A (if he itemizes his deductions), as the debt is secured by his home and is less than the $100,000 limit for equity indebtedness.  However, if Brandon doesn’t itemize his deductions or they are subject to the itemized deduction phase-out he would lose some or all of the benefit from the interest paid. Therefore, he is permitted to make an irrevocable election to treat the debt as not being secured by his home and thus the tracing rules would apply. The result is that he would get the full benefit of the interest paid by deducting it as a business expense on his Schedule C.

Scenario 3:  Stephanie borrows $25,000 on a margin account held by her broker. The debt isn’t secured by her home. She uses the $25,000 to buy shares of Apple stock. The interest she pays on the margin account is treated as investment interest and is deductible to the extent of her net investment income.

As you can see, it is very important to plan your financing moves carefully, especially when equity in one asset is being used to acquire another.  Call our office for assistance in applying the various interest expense limitations and tracing rules to ensure you get the appropriate tax benefits.